The historical cost accounting values an asset for balance sheet purposes at the price paid for the asset at the time of its acquisition. The historical cost accounting is the situation in which accountants record revenue, expenditure and asset acquisition and disposal at historical cost: that is, the actual amounts of money, or money’s worth, received or paid to complete the transaction.
Historical cost is based on actual transaction rather than forecasts. There are supporting records for all the figures provided in the financial statements. It is also relevant in making economic decisions, as past data transactions are needed for making future decisions. Another defense of historical cost is that ‘historical cost’ has been used throughout history as financial statements which use historical cost are found to be useful.
Profit is the excess of selling price over historical cost. Profit is a very well accepted concept of measure of performance. It is the difference between revenue and cost that determines on decision to continue a product line or division. Historical Cost Accounting is very much based on this concept of profit and loss.
Others, in defense of Historical Cost Accounting argue that historical cost is less subject to manipulation of data than other forms of accounting such as Current Cost. The use of current cost or exit price opens the door to manipulation of these numbers. In other words, how are current costs to be determined and how can accountants determine which value is true and fair? More importantly accountants must guard the integrity of their data against internal modification.
Criticisms of Historical Cost Accounting
Overtime, criticisms of historical cost accounting have been raised by number of notable scholars, particularly in relation to its inability to provide useful information in times of rising prices. Historical Cost Accounting record all assets at an original cost and continue to use these historic figures throughout the asset’s life, while time-value of money is completely ignored.
Across time these criticisms appear to have been accepted to a certain degree by accounting regulators. In recent years various accounting standards have been released that require the application of fair values when measuring assets. For example AASB 116 gives financial statement preparers a choice between the cost model and the fair value model in measurement of property, plant, and equipment. Financial Instruments (AASB 139), investment properties (AASB 114), and biological assets (AASB141) are required to be valued at fair value as opposed to historical cost.
The historical cost accounting information suffers from problems of irrelevance in times of rising prices. It is also questioned whether it is useful to be informed about something that cost a particular amount many years ago whereas its current value might be considerably different. It has been argued that there is a real problem of additivity. The matter at issue is whether it is logical to added together assets acquired at different periods when those assets were acquired with amounts of different purchasing power.